Russian Federal Law №227- FZ dated 18 July 2011 (the Law) has introduced a whole section V.1 to the Tax Code dedicated to transfer pricing rules and tax control over transactions between related parties, which were earlier regulated only by two articles (Article 20 and Article 40 of the Tax Code). The new rules entered into force on 1 January 2012 (save for certain provisions).
The main international advisory document in this area is the OECD Transfer pricing guidelines for multinational enterprises and tax administrations. National legislation of many countries follow the provisions of this document, however the scope of application and status of OECD Guidelines varies between jurisdictions.
Generally, OECD Guidelines apply to international (cross-border) transactions, governing taxation in the context of international tax planning. Therefore, in many countries the legislation controls only taxation of cross-border transactions to prevent tax avoidance at a national level and keep the main taxable base in their jurisdiction. However, in some countries transfer pricing rules also apply to local transactions.
New Russian transfer pricing rules, for the most part, adopt worldwide practices and OECD Guidelines related to transfer pricing, however, there are certain Russian specific provisions. Among the new provisions introduced by the Law are: substantial extension of related persons list, new transfer pricing methods, reporting and transfer pricing documentation requirements, special transfer pricing
audits and penalties, and Advance Pricing Agreements (APA).
Transfer pricing and its objectives
The Russian Tax Code does not contain the definition of “transfer pricing” merely establishing the rules aimed at transfer pricing control. Generally, the term “transfer price” shall mean a price set by a taxpayer when selling to, buying from, or sharing resources with a related party. The term transfer pricing usually applies to prices used by the companies (mainly by holding companies) for transactions between its subdivisions, branches, affiliates, related persons, i.e. inside the company’s group structure for foreign and domestic transactions.
As mentioned earlier, transfer pricing usually applies in the context of international tax planning and its purpose for the taxpayer is usually to shift the profit from a high tax jurisdiction to a low tax jurisdiction, to apply tax incentives provided by national laws, to increase or decrease goods value etc. thus minimising the overall tax burden of the group of companies engaged in one business, i.e. related parties.
To avoid abuse of transfer pricing by companies for tax purposes, they are controlled by the state tax authorities to comply with market levels and governments implement special provision in their laws to regulate transfer pricing issues. Russian law controls both local and cross-border transactions.
Before the Law came into force, Article 20 of the Russian Tax Code outlined three criteria to be met for parties to be treated as “related”:
- share of direct or indirect participation of one company in another’s’ equity is greater than 20%;
- one individual is subordinate to another one by virtue of official capacity; and
- parties are relatives according to Russian family law.
The courts could declare parties to be related for reasons other than those specified in the Tax Code if the relationship between the parties can affect the outcome of the transaction.
The Law has introduced additional criteria for “reliance”, thus substantially extending the list up to 11 items and making the definition broader. Under the Law, parties will generally be treated as related when the nature of their relations can affect the terms and/or the result of the transactions entered into by these parties, and/or the economic result of the activity of these parties or the activity of the persons represented by them.
The parties are also considered to be “related” when one party may affect another party as a result of the participation of one party in the equity of other party, according to the agreement signed between them or as a result of other grounds for one party to affect the decisions made by the other party.
The Law recognises the following parties as related:
- companies in the case where one company directly and (or) indirectly participates in the other company’s equity and the share of such participation is greater than 25%;
- individuals and companies in the case that such individual directly and/or indirectly participates in such company’s equity and the share of such participation is greater than 25%;
- companies in the case that the same person directly and/or indirectly participates in the companies’ equity and the share of such participation in each company is greater than 25%;
- companies and persons (including an individual together with his interdependent persons), having powers to appoint (elect) a sole executive body of this company or to appoint (elect) not less than 50% of members of the collective executive body or board of directors (supervisory board) of this company;
- companies having sole executive bodies or collective executive bodies or a board of directors (supervisory board), where not less than 50% of members are appointed or elected by the same party (individual together with interdependent persons);
- companies with a collective executive body or board of directors (supervisory board), where more than 50% of members are the same individuals together with the interdependent persons;
- companies and persons, being its sole executive body;
- companies, where the same person is a sole executive body;
- companies and/or individuals in cases where the share of direct participation of each previous party in each subsequent company is greater than 50%;
- individuals in the case where one individual is subordinate to another one by virtue of official capacity;
- individuals, their spouses, parents (including adoptive), children (including adopted), full-blood and half-blood brothers and sisters, guardians and wards.
The courts have retained the right to recognise parties related for reasons other than those stipulated by the law if the relationship between the parties may have an impact on the conditions and outcome of a transaction performed by these parties or the results of their economic activity.
Under the old rules effective until 2012, Russian tax authorities were entitled to challenge the pricing arrangements between taxpayers only in the following cases:
- transactions between related parties (domestic and cross- border);
- barter transactions;
- foreign trade transactions; and
- transactions where the prices within the short period of time deviate by more than 20% either way from the prices set by the taxpayer for identical or similar goods (work, services).
The Law introduces a new term for Russian tax legislation, “controlled transaction,” which means transactions between related parties and transactions directly specified by law as controlled. If the transaction is a “controlled transaction” then it is subject to transfer pricing rules and tax authorities may control the pricing arrangements between the parties and challenge those if they fall outside the scope of the Tax Code provisions.
The following transactions are listed as controlled and subject to the transfer pricing regime:
- sale of goods (work, services) involving third-party intermediaries;
- cross-border transactions, if the transaction amount exceeds RUB60 million (USDI.8 million) in a calendar year and one of the following applies:
- a transaction involves goods traded on commodity markets, such as oil, precious metals and gem stones, fertilizers, non-ferrous and ferrous metals; or
- a transaction involves companies being residents of low tax jurisdictions (offshore companies on black list of Ministry of Finance);
- if the aggregate annual amount of income resulting from transactions between Russian companies exceeds, in a calendar year, RUB3 billion in 2012 (USD93 million), RUB2 billion in 2013 (USD62 million), and RUBI billion (USD3I million) starting from 2014;
- transactions between Russian companies, if the transaction volume exceeds RUB60 million (USDI.8 million) in a calendar year, and one of the following applies:
- the transaction involves operations with mineral resources subject to ad valorem rate of mineral extraction tax (MET), and one of the parties is a MET taxpayer at ad valorem rate; or
- one of the parties does not pay profits tax, or pays it at 0% rate (e.g. a participant in project “Skolkovo,” educational or medical companies); or
- one of the parties is a resident of a special economic zone (this provision will come into force on I January 2014)
- one of the parties pays unified tax on imputed income; or
- one of the parties pays unified agricultural tax.
Transactions between companies that are members of a consolidated taxpayer group are not subject to the transfer pricing regime. Possible exceptions may apply, for example, if both parties to a controlled transaction are registered in the same region, do not have separate subdivisions in other regions and abroad, do not pay taxes in other regions, do not generate losses and do not fall under points 4 and 5 above.
The above rules relating to controlled transactions are in line with those of the OECD model, however, new Russian transfer pricing rules have also implemented certain anti- avoidance elements by introducing direct control over cross-border transactions involving residents of low-tax jurisdictions.
Transfer pricing methods
Russian law specifies five methods to be applied by the tax authorities when adjusting taxable income to transactions where the parties are related. Those methods are traditional worldwide practice and are generally in line with OECD Guidelines, however, Russian law provides a hierarchy of listed methods. The preferred method is the Comparable Uncontrolled Price (CUP) method and other methods can be applied by tax authorities only if it is impossible to apply the previous ones. The application of two of a combination of methods is permitted:
Comparable uncontrolled price method – this method compares the price charged in a controlled transaction to the price range charged in a comparable uncontrolled transaction in similar circumstances.
Resale price method – the resale price method establishes the arm’s length price for the sale of goods between related parties by subtracting an appropriate markup from the price at which the goods are ultimately sold to unrelated parties.
Cost plus method – the cost plus method uses the manufacturing and other costs of the related seller to establish the arm’s length price.
Transactional net margin method – this is sometimes also referred to as the comparable profit method and it compares operational profit margin gained by the taxpayer under the controlled transaction with operational profit margin realised by arm’s length parties under comparable uncontrolled transactions.
Profit split method – this compares operating profit allocated between the related parties under controlled transactions, in proportion to the relative contributions they are considered to have made in earning the income in a common line of business, with that allocated by arm’s length parties under similar uncontrolled transactions.
Sources of information – the information required to determine market price/profitability should be obtained only from available sources, in particular:
- prices and quotations from stock or commodity exchanges (both domestic and foreign);
- customs data relating to Russian overseas trade;
- official sources of information on prices (and price fluctuations) and exchange quotations held by the federal, regional and local authorities, including statistical data; also, official sources held by foreign countries and international organisations or contained in other published and/or available publications and databases;
- information prepared by special pricing agencies;
- information on taxpayer’s own transactions (internal comparables).
If the information contained in the above sources is not available or is insufficient, the following information may be used:
- information on prices (and price fluctuations) and exchange quotations obtained from published and/or available publications and databases;
- information from company accounts and statistical reports, including that published in available Russian or foreign publications and databases;
- information from independent appraisers;
- other information.
- Transfer pricing documentation
- Taxpayers shall prepare and keep specific transfer pricing documentation of the total amount of income received by the taxpayer from all controlled transactions with the same counterparty which exceeds RUBI00 million (USD3 million) in 2012 and RUB80 million (USD2.5 million) in 2013. These restrictions will not be applicable after 2014.
Transfer pricing documentation shall include the following information:
- information about the taxpayer, the structure and terms of the transaction, the parties involved and their functions;
- a description of the transfer pricing methods, sources of information used, and rationale for the choice of transfer pricing method;
- information on other factors that might influence the price (e.g. marketing strategy); and
- information on adjustments to the tax base.
The tax authorities are allowed to request transfer pricing documentation from taxpayers not later than I June of the year following the calendar year in which the controlled transactions occurred. A taxpayer is obliged to file the documentation with the tax authorities within 30 days after receiving their request.
According to the new law, if prices are regulated by the Russian authorities or established in accordance with anti-monopoly law, or the transaction relates to securities and financial instruments traded on the stock exchange, Russian tax authorities shall accept such prices for tax purposes.
At the end of each calendar year (on 20 May of the year following the reported year) the taxpayers shall inform the tax authorities on the controlled transactions which occurred in that year.
Advanced pricing agreements (APAs)
Russian law allows the taxpayer to enter into an Advanced Pricing Agreement (APA) with the tax authority. This rule is revolutionary for Russia and allows the taxpayer to agree with the tax authority the method applied to the pricing applicable to controlled transactions at the stage when the transaction (group of transactions) is planned, and the tax authority approves that method and cannot change it during the term of such agreement. The tax authority is allowed to correct the method applicable only in cases when the terms of APA were breached by the taxpayer.
It is important to note that conclusion of an APA is a very complex and time consuming process for a company. When entering into an APA with the tax authority, the taxpayer is subject to a detailed tax audit of his activities and pricing policy applied earlier and provides a lot of commercial information about the company. Therefore, certain tax risks for the taxpayer may arise.
APAs are available only for “major taxpayers” (annual tax payments exceeding RUBI billion (USD3I million) or annual revenue/assets exceeding RUB20 billion (USD625 million)). The tax authorities have six months to review an APA application, which can be extended to a maximum of nine months. An approved APA shall be valid for three years and may be extended for an additional two years at the taxpayer’s request. An APA shall not be changed even if relevant provisions of tax legislation are amended.
The new law provides the potential participation of foreign tax authorities in APAs, provided one of the companies
involved is tax resident of that foreign state and there is a double tax treaty between Russia and that country in place.
A modification to a transfer price used by one taxpayer to take account of a modification made to the transfer price used by an affiliated taxpayer is referred to as a “correlative adjustment” and widely applied in most developed countries. This rule allows for the avoidance of double taxation of the same transaction within the group of companies.
Under Russian law, “correlative adjustment” takes place only when the tax authorities impose an additional tax assessment on a taxpayer as a result of transfer pricing audit and in this case the taxpayer’s counterparty is allowed to make an adjustment to its tax base only upon receipt of notification from the tax authority. The procedure for correlative adjustments is outlined in the Tax Code and may be applied to four taxes only – corporate income tax, VAT, MET and individual income tax.
Correlative adjustments apply to local transactions only and do not apply to cross-border transactions.
Technically, the new law does not prohibit the taxpayers from making voluntary adjustments to the tax base in accordance with the chosen transfer pricing method and file amended tax returns. However, those are not considered as “correlative adjustments” under the law and there is a high risk that the taxpayer, which has made downward adjustment and, therefore, decreased its tax liabilities will be subject to additional tax audit by the tax authorities.
Though the new Russian transfer pricing rules are similar to the OECD model, certain differences do exist. As soon as Russia is not an OECD member and OECD Guidelines are not applicable, differences between OECD model and Russian legislation and Russian specifics shall be taken into account by international corporations doing business in Russia and adapted to their corporate patterns. Hence, in some cases, Russian law treats foreign trade transactions between unrelated parties as “controlled transactions,” which is not typical for OECD member countries. Also, unlike OECD Guidelines, Russian law provides a hierarchic order of transfer pricing methods, as well as opportunity for APAs only for Russian companies.
Following the entry into force of the Law №227-FZ to minimise tax risks associated with transfer pricing requirements, the taxpayers shall:
- develop the internal procedures to identify and review the transactions which can be recognised as “controlled transactions” both at the stage of preparation and execution and monitor turnover on such transactions;
- determine the transfer pricing method applicable to the company’s activities;
- approve a list of information sources to be used for determination of market prices;
- establish transactional net margin for the goods (services) sold;
- compare transactional net margin level meeting the requirements of the law with margin acceptable by customs and/or antimonopoly bodies’ requirements, as well as other legislative requirements applicable to the company.
Article from “Offshore Investment” Magazine,
September 2012, Issue 225